Speech
Achieving Effective Supervision

Introduction

By the middle of 1998, legislation permitting, a new regulatory agency will come
into existence. It will reflect the Wallis Committee's call for a more
integrated and consistent approach to prudential supervision and regulation,
geared towards a rapid pace of change in the financial system and an increasing
prevalence of financial conglomerates. APRA, the Australian Prudential Regulation
Authority, will combine the banking supervision functions of the Reserve Bank
with the activities currently carried out by the Insurance and Superannuation
Commission. On present plans, the new agency will be supplemented in the middle
of 1999 by inclusion of the supervisory functions of AFIC (the supervisor of
building societies and credit unions). With the Wallis Committee's recommendation
on this accepted by the Government, the key challenge now is to put in place
the new arrangements to achieve a flexible regulatory system focusing on both
the prudential soundness of the financial system and, importantly, financial
system efficiency.

Issues

As a preliminary, I should make the obvious point that the new arrangements are not
starting from scratch (or worse, starting with a financial system which is
in trouble, or a regulatory system which is deficient). The new arrangements
build on a well-functioning system, but seek to adapt it to expected future
developments. The task is to take over the best features of the current approach,
to continue the kind of adaptive evolution which has occurred, and to tailor
the existing institutions more precisely to achieve a snug fit with the demands
of a fast-changing financial sector. It is never possible to achieve perfect
congruence between institutional arrangements and multi-dimensional needs,
but there is now a new opportunity to re-align institutions and methods. The
various objectives will not flow automatically or easily, however, from creating a single prudential
regulator. So there is some point in offering some thoughts, as the Bank passes
on the baton to the next runner, urging them to run the good race. In that
spirit, let me offer the following comments.

First, I will touch on the issue of flexibility. There can be a tendency for regulators
covering a wide institutional field to become more highly bureaucratic than
those with a narrow focus. A legalistic, accounting-based approach to regulatory
matters can emerge over time. Why is that the case? The answer is relatively
simple. Big institutions by their nature tend also to be complex institutions.
The simplicity, flexibility and innovation that is often the hallmark of a
smaller entity can fade with size. This view should not be especially controversial
for it applies to most organisations and institutions – it is why the
small to medium business sector is often viewed as the engine for growth and
employment in the economy. It is why mergers of smaller businesses into large
corporates often fail to deliver the expected benefits.

Sometimes large regulators also have large rule books which are often written into
legislation. The rationale is usually that this approach is more consistent
with the notion of the level playing field, with everybody in the market knowing
the rules of the game. There is often, also, a strong sense that supervisors
should not be permitted to make arbitrary judgments on policies or supervisory
approaches. Policy is policy and should be applied to the letter of the law
until it is changed. It is an approach that is administratively tidy. Yet,
there is also a big cost, for as soon as you proceed down that legalistic path,
flexibility can disappear.

Regulatory rule books can, of course, always be rewritten and legislation changed
where circumstances warrant but the time scales involved in achieving change
through that channel can be measured not in days or weeks but sometimes in
terms of years. The history of the Capital Adequacy Directives in the European
Union is compulsory and sobering reading for anyone who might question this
view.

In developing APRA, therefore, it will be important to keep those dynamics firmly
in mind. The financial system of the future will require an increasingly flexible
and quick-footed approach to prudential supervision and one of the key challenges
will be to ensure that the regulatory system meets that need. Financial institutions
should be able to get a quick answer when they come to the regulator with a
proposal. They should also feel that they do not have to be accompanied by
their lawyer.

There is every reason to believe that this objective can be achieved if it is kept
in mind. A noteworthy feature over the past five or so years has, in fact,
been the increasing trend internationally towards ‘market friendly’
approaches to supervision. One example of this trend in Australia is the development
of the on-site visit programs to banks, covering first credit risk and, more
recently, market risk. Such developments can be described as market friendly
not because they have led to any easing of prudential standards, but because
they reflect an approach to supervision that aligns itself more to the way
that banks themselves think about and address risk. Rather than requiring banks
to provide reams of standardised statistical data on, say, the health of their
credit portfolios, the approach has been to reach in to the information and
data that the individual banks have developed for their own credit risk management
purposes, and to examine the systems and controls in place to measure and manage
the risk. The same approach applies in relation to the supervision of traded
market risk in banks and, in theory, could apply to all other forms of risk
facing financial institutions.

By taking that path, the supervisory burden on institutions is reduced, supervisors
get better information than could otherwise be obtained and, through closer
interaction between the bank and the supervisor, the result is a much improved
understanding between the two par ties. It should be recognised, however, that
it is also a more difficult approach to adopt and can make consistency of treatment
across institutions harder to achieve. It is not as tidy as the traditional
approach. It requires supervisors to know more about the businesses they supervise.
It is also an approach that, possibly, may be at odds with the natural inclination
of some supervisors or regulators to stay quite removed from the activities
and institutions they monitor. The outcome of the preferred approach, however,
is a much better balance between prudential objectives and market efficiency.

As we look to the future of the financial system, and to the development of prudential
standards over time, there is no doubt that this approach of utilising institutions'
own risk measurement and management systems, and of requiring the management
and Boards of institutions to vouch for the adequacy of those systems, must
be the way forward.

As mentioned earlier, the Wallis proposals for a single prudential supervisor also
turned very much on the idea that the process of financial intermediation,
and financial services more generally, was blurring and becoming less distinct.
The implication is that the supervision of different types of financial entities
should be more consistent and integrated within a single agency. There are
a couple of dimensions to this. At the simplest level, while the broad policies
applying to what we currently define as banks and building societies can be
reasonably aligned, the supervisory approach adopted and the techniques applied
to an intermediary with a balance sheet of $150 billion will be quite different
from the situation where a balance sheet of $50 or $100 million or less is
involved. I think that point is well understood.

Integrating supervisory approaches applied variously to deposit-takers or intermediaries,
traditional forms of insurance and superannuation will be very complex. There
is a real opportunity, however, for APRA to smooth out some of the regulatory
inconsistencies which currently exist between banks and insurance companies
especially. Not all of these inconsistencies will be capable of being ironed
out, simply because of the nature of the different sorts of businesses conducted
by banks and insurance companies. The practical task will be to look for the
areas of commonality between deposit-takers and insurance businesses especially,
and develop consistent policy where it is possible. That should be an early
priority for the new regulatory agency.

The new framework should handle conglomerates more neatly than at present, but bringing
different institutions under one regulatory roof should not be allowed to disguise
differences in underlying characteristics of the various institutions or the
products they offer. APRA should work hard to spell out the boundaries between
financial instruments offering capital guarantees and the market-linked returns
found more frequently in the superannuation area. Those distinctions are likely
to remain over the long term. It will be important to ensure that any confusion
in the mind of the investing public between these product boundaries is not
accentuated by the presence of a single prudential authority covering banking
and superannuation.

I want to say something about supervisory philosophy because, ultimately, I think
it is the key to achieving effective supervision. Whether it is in relation
to the style of supervision, or the policies applied, or the approach to integrating
supervisory arrangements across different types of institution, the model has
to be forward looking and innovative. I would summarise all this by saying
that APRA should be very much a policy-driven, not process-oriented, agency.
Analytical effort is central to the task, which will require it to invest in
a significant financial research capability. That last point will come as a
surprise to some who would not normally associate supervision and regulation
with a strong research focus. Research, policy and good supervision are inextricably
linked. I would go as far as to say that in a dynamic financial system, supervision
is likely to be ineffective and generate significant financial inefficiencies
unless it is backed up by high-level research and analytical effort focusing
on broad developments in the structure of the financial system, trends within
financial institutions, financial markets and the interconnections between
them. The characteristics of emerging financial products and instruments need
to be understood and leading edge work must be done in the area of risk measurement
and management and in the modern finance theories which increasingly underlie
developments in this field.

Only by carrying out work of this nature can supervisors be attuned to emerging developments
in the system and be capable of responding accordingly. Only through an emphasis
on research, and the spreading of the resulting work into the closely related
policy area, and then into the operational sides of the institution as a whole,
that you can guarantee that supervisors will be credible in the eyes of the
people they deal with day-to-day – the supervised institutions. There
is a good deal of evidence to back this view. Come the end of this year, the
Reserve Bank will be one of the few banking supervisor s internationally to
implement the internal models approach to traded market risk. The reason I
believe we will be in a position to do so links back to the research work carried
out on market risk, financial instruments, evolving risk methodologies, and
so forth, over the past four or five years. Some overseas supervisory agencies
that have not devoted resources to market related analytical and research activities
are lagging the field. The problem, of course, is that the institutions they
supervise are not lagging, the effect being that regulatory arrangements are
holding back the market and creating inefficiencies.

As I mentioned a little earlier, these approaches we have applied to traded market
risk, involving the use of sophisticated models and reliance on more rigorous
risk management frameworks, will come to be applied to other forms of risk
(credit risk, operational risk, etc.) and to institutions other than the banks.
APRA should have the capability to deal with those eventualities.

Conclusion

I will conclude with the thought that there is now a very strong commitment within
the Australian regulatory community to APRA and to ensuring that it becomes
a first-rate prudential supervisor capable of handling the issues likely to
be confronted within the financial system over the next decade. Success as
a prudential supervisory agency will not flow solely, however, from the reorganisation
of functions between the current set of prudential regulators. Rather, it will
be a product of the development of an appropriately flexible market-oriented
philosophy within the new authority. A dynamic, policy-driven institution,
feeding off strong research capabilities which, in turn, feed into equally
robust operational areas, will achieve the objectives set for it by the Wallis
Committee and the Government.